Regulating Banks

In a recent column about Allan Meltzer's new book Why Capitalism?, I mentioned Professor Meltzer's first law of regulation: "lawyers and bureaucrats regulate," but "markets circumvent regulation."

Today's case in point comes from the Wall Street Journal, which reports:

Deutsche Bank AG changed the legal structure of its huge U.S. subsidiary to shield it from new regulations that would have required the German bank to pump new capital into the U.S. arm.The bank on Feb. 1 reorganized its U.S. subsidiary, known as Taunus Corp., so that it is no longer classified as a "bank-holding company," according to disclosures by the bank and on the U.S. Federal Reserve's website. Deutsche Bank is at least the second large European bank to make such a change, following in the footsteps of the U.K.'s Barclays PLC....Deutsche Bank disclosed the change in a footnote on page 347 of its annual report, which was published on Tuesday. It said the change was effective Feb. 1.

Meanwhile, on the topic of the bank regulation, don't miss the annual report released yesterday evening by the Federal Reserve Bank of Dallas.

An introductory letter from the president of the bank, Richard Fisher, says that the Dodd-Frank law "does not eradicate" Too Big To Fail. "Indeed, it is our view at the Dallas Fed that it may actually perpetuate an already dangerous trend of increasing banking industry concentration," Mr. Fisher writes. "Perhaps the most damaging effect of propagating TBTF is the erosion of faith in American capitalism. Diverse groups ranging from the Occupy Wall Street movement to the Tea Party argue that government-assisted bailouts of reckless financial institutions are sociologically and politically offensive. From an economic perspective, these bailouts are certainly harmful to the efficient workings of the market....In my view, downsizing the behemoths over time into institutions that can be prudently managed and regulated across borders is the appropriate policy response. Only then can the process of 'creative destruction'— which America has perfected and practiced with such effectiveness that it led our country to unprecedented economic achievement— work its wonders in the financial sector, just as it does elsewhere in our economy."

The Dallas Fed annual report also includes an essay by the head of the Dallas Fed's research department, Harvey Rosenblum, that is written in clear, accessible language (Richard Alm is credited for "journalistic assistance") and that is worth a look. The essay doesn't let the Fed off the hook, either: "The Fed kept interest rates too low for too long, contributing to the speculative binge in housing and pushing investors toward higher yields in riskier markets."

Another key point from Mr. Rosumblum's essay is this: "For capitalist economies to thrive, weak companies must go out of business.The reasons for failure vary from outdated products, excess industry capacity, mismanagement and simple bad luck.The demise of existing firms helps the economy by freeing up resources for new enterprises, leaving healthier survivors in place."

And, also, this: "psychological side effects of TBTF can't be measured, but they're too important to ignore because they affect economic behavior. People disillusioned with capitalism aren't as eager to engage in productive activities. They're likely to approach economic decisions with suspicion and cynicism, shying away from the risk taking that drives entrepreneurial capitalism. The ebbing of faith has added friction to an economy trying to regain cruising speed."

And this: "It could be argued that zero interest rates are taxing savers to pay for the recapitalization of the TBTF banks whose dire problems brought about the calamity that created the original need for the zero interest rate policy."

I don't agree with everything in Mr. Rosenblum's essay, but, as I said before, it's worth a look. One of my concerns is that any effort to "break up the giant banks," as Mr. Rosenblum recommends, not trample on the property rights of the shareholders of those banks. Another is that the concentration and largeness that Mr. Rosenblum decries in the banking sector is very much in line with trends in other parts of the economy, and it seems unreasonable to suggests that banks should be an exception to those trends. And another is that size doesn't necessarily translate into fragility. Canada, for example, has big banks, but those weathered the financial crisis pretty well.